In this paper we set up a model of start-up finance under double moral hazard.
Entrepreneurs lack own resources and business experience to develop their ideas.
Venture capitalists can provide start-up finance and commercial support. The effort
put forth by either agent contributes to the firm’s success, but is not verifiable. As
a result, the market equilibrium is biased towards inefficiently low venture capital
support. The capital gains tax becomes especially harmful, as it further impairs
advice and causes a first-order welfare loss. Once the capital gains tax is in place,
limitations on loss off-set may paradoxically contribute to higher quality of venture
capital finance and welfare. Subsidies to physical investment in VC-backed startups
are detrimental in our framework.
Keywords: Venture capital, capital gains taxation, double moral hazard.
JEL-Classification: D82, G24, H24, H25